Capital Markets

Surprise: Junk Credit Quality Improves

September’s interest-rate cut sparks an abrupt reversal in the level of distressed debt.
Stephen TaubNovember 2, 2007

There’s nothing like a cut in interest rates to improve credit quality.

After rising for two months, and threatening to climb even higher, the distressed-debt ratio fell to 2.3 percent in October from 3.2 percent the previous month, according to a new report from Standard & Poor’s. Not only did a seemingly burgeoning trend abruptly reverse, but the fallback was large in magnitude. At 2.3 percent, the distress ratio is now below the 2.6 percent level recorded 12 months ago.

“Much of this reduction is attributed to the narrowing of spreads after the Federal Reserve reduced the federal funds rate by 50 basis points on September 18,” says Diane Vazza, head of Standard & Poor’s Global Fixed Income Group.

Distressed credits are defined as speculative-grade-rated issues that have spreads of more than 1,000 basis points relative to Treasuries.

The bond-distress ratio is the number of speculative-grade (junk) credits with option-adjusted spreads above 1,000 basis points divided by the total number of speculative-grade credits. A rising distress ratio signals an increased need for capital and could act as a precursor to more defaults if accompanied by a market disruption, the ratings company explains.

S&P notes that after five consecutive months of relative stability at less than 1 percent, the distress ratio has become more volatile in the past three months. It also points out that all significant basis-point thresholds showed declines. Most noticeable was the 42 percent drop at the 600 basis-point level, month over month. This compares with 10 percent at 800 basis points and 29 percent at 1,000.

Meanwhile, there were other signs of credituality improvement. For example, the average spread for nondistressed speculative-grade bonds fell to 392 basis points on October 15 from 444 basis points on September 13.

In addition, the total number of rated companies with issues trading at distressed levels dropped to 120 from 168. Of the 120 companies on this month’s distressed list, 60 percent had either negative outlooks or ratings on CreditWatch with negative implications. The outlook for 29 percent of the companies was stable; for 5 percent, positive; and for 6 percent, developing.

Of the 32 companies listed at the 1,000 basis points level, 22 were rated B- or lower, and 26 were on CreditWatch with negative implications or had negative outlooks.

The story was different in the leveraged-loan market: the distress ratio climbed to 1.44 percent in September from 1.17 percent the previous month, and stayed above 1 percent for the second straight month since November 2005.